No, I don't think the people making this pronouncement realize that they sound just like Dr. Evil in the Austin Powers movies.

Anyway, we do indeed have a ONE TRILLION DOLLAR deficit,... actually $1.089 trillion. ... What the Dr. Evil types think, and want you to think, is that the big current deficit is a sign that ... a debt crisis is just around the corner, although they've been predicting that for years and it keeps not happening. ... But more often they use the deficit to argue that we can't afford ... programs like Social Security, Medicare and Medicaid. So it's important to understand that this is completely wrong. ...

So, let's talk about the numbers. The first thing we need to ask is what a sustainable budget would look like. The answer is that in a growing economy, budgets don't have to be balanced to be sustainable. ... Right now, given reasonable estimates of likely future growth and inflation, we would have a stable or declining ratio of debt to G.D.P. even if we had a $400 billion deficit. You ... should take $400 billion off the table right away.

That still leaves $600 billion or so. What's that about? It's the depressed economy — full stop.

First of all, the weakness of the economy has led directly to lower revenues ... by at least $450 billion. Meanwhile, the depressed economy has ... temporarily raised spending ... by at least $150 billion.

Putting all this together, it turns out that the trillion-dollar deficit isn't a sign of unsustainable finances at all. ... We do indeed have a big budget deficit, and other things equal it would be better if the deficit were a lot smaller. But other things aren't equal; the deficit is a side-effect of an economic depression, and the first order of business should be to end that depression — which means, among other things, leaving the deficit alone for now.

And you should recognize all the hyped-up talk about the deficit for what it is: yet another disingenuous attempt to scare and bully the body politic into abandoning programs that shield both poor and middle-class Americans from harm.

So far, the debate has focused on scaling back provisions of the tax code that have favored activities traditionally deemed to be valuable..., reducing reliefs for charitable contributions, taxes paid to state and local governments, home mortgages, employer-provided health insurance and many less important provisions. There are reasonable arguments ... in each case. But taking only the "limit tax incentives" approach to tax reform has several major defects. [lists] ...

What is needed is an additional element, one that has largely been absent to date: the numerous exclusions from the definition of adjusted gross income... There are far too many provisions that favor a small minority of very fortunate taxpayers. ... it should not be possible to accumulate and transfer large fortunes while avoiding taxation almost entirely. Yet this is all too possible today. ... [lists several ways] ...

I believe it is plausible to raise $1tn over the next 10 years by going after provisions that cause what adds to wealth and spending not to be regarded as income.

It has been observed that the greatest scandals are not the illegal things that people do but the things that are fully legal. This is surely true with respect to a tax code in urgent need of reform.

[If you can't get to the article, it usually appears on the Washington Post's editorial page later in the day, though sometimes the editing is slightly different. Update: It's here.]

Simon Wren-Lewis takes issue with Stephen Williamson's claim that "there are good reasons to think that the welfare losses from wage/price rigidity are small":

Mistaking models for reality, by Simon Wren-Lewis: In a recent post, Paul Krugman used a well known Tobin quote: it takes a lot of Harberger triangles to fill an Okun gap. For non-economists, this means that the social welfare costs of resource misallocations because prices are 'wrong' (because of monopoly, taxation etc) are small compared to the costs of recessions. Stephen Williamson takes issue with this idea. His argument can be roughly summarized as follows:

1) Keynesian recessions arise because prices are sticky, and therefore 'wrong', so their costs are not fundamentally different from resource misallocation costs.

2) Models of price stickiness exaggerate these costs, because their microfoundations are dubious.

3) If the welfare costs of price stickiness were significant, why are they not arbitraged away?

I've heard these arguments, or variations on them, many times before.[1] So lets see why they are mistaken...

But I want to focus on this. How useful are representative agent models, e.g. New Keynesian models, for examining questions such as the costs of unemployment?:

Lets move from wage and price stickiness to the major cost of recessions: unemployment. The way that this is modeled in most New Keynesian set-ups based on representative agents is that workers cannot supply as many hours as they want. In that case, workers suffer the cost of lower incomes, but at least they get the benefit of more leisure. Here is a triangle maybe (see Nick Rowe again.) Now this grossly underestimates the cost of recessions. One reason is heterogeneity: many workers carry on working the same number of hours in a recession, but some become unemployed. Standard consumer theory tells us this generates larger aggregate costs, and with more complicated models this can be quantified. However the more important reason, which follows from heterogeneity, is that the long term unemployed typically do not think that at least they have more leisure time, so they are not so badly off. Instead they feel rejected, inadequate, despairing, and it scars them for life. Now that may not be in the microfounded models, but that does not make these feelings disappear, and certainly does not mean they should be ignored.

It is for this reason that I have always had mixed feelings about representative agent models that measure the costs of recessions and inflation in terms of the agent's utility.[2] In terms of modeling it has allowed business cycle costs to be measured using the same metric as the costs of distortionary taxation and under/over provision of public goods, which has been great for examining issues involving fiscal policy, for example. Much of my own research over the last decade has used this device. But it does ignore the more important reasons why we should care about recessions. Which is perhaps OK, as long as we remember this. The moment we actually think we are capturing the costs of recessions using our models in this way, we once again confuse models with reality.

What does me mean by confusing models with reality?:

The problem with modeling price rigidity is that there are too many plausible reasons for this rigidity - too many microfoundations. (Alan Blinder's work is a classic reference here.) Microfounded models typically choose one for tractability. It is generally possible to pick holes in any particular tractable story behind price rigidity (like Calvo contracts). But it does not follow that these models of Keynesian business cycles exaggerate the size of recessions. It seems much more plausible to argue completely the opposite: because microfounded models typically only look at one source of nominal rigidity, they underestimate its extent and costs.

I could make the same point in a slightly different way. Lets suppose that we do not fully understand what causes recessions. What we do understand, in the simple models we use, accounts for small recessions, but not large ones. Therefore, large recessions cannot exist. The logic is obviously faulty, but too many economists argue this way. There appears to be a danger in only 'modeling what we understand' that modelers can go on to confuse models with reality.

Let me add that while this is a good argument for why the measured costs only establish a minimum bound for the total costs, I am not sure we can be confident they do that. The reason is that I am not convinced that wage and price rigidities as modeled in the New Keynesian framework adequately capture the transmission mechanism from shocks to real effects that propelled us into the Great Recession. That is, do we really think that wage and price rigidities of the Calvo variety (or of the Rotemberg variety) are the main friction behind the downturn and struggle to recover? If prices were perfectly flexible, would our problems be over? Would they have never begun in the first place? More flexibility in housing prices might help, but the problem was a breakdown in financial intermediation which in turn caused problems for the real sector. Capturing these effects requires abandoning the representative agent framework, connecting the real and financial sectors, and then endogenizing financial cycles. There is progress on this front, but in my view existing models are simply unable to adequately capture these effects.
If this is true, if existing models do not adequately capture the transmission of financial shocks to changes in output and employment, if our models miss a fundamental mechanism at work in the recession, why should we believe estimates of fiscal multipliers, welfare effects, and so on based upon models that assume shocks are transmitted through moderate price rigidities? I think these models are good at capturing mild business cycles like we experienced during the Great Moderation, but I question their value in large, persistent, recessions induced by large financial shocks.
[For more on macro models, see Paul Krugman's The Dismal State of the Dismal Science and the links he provides in his discussion.]